What Is The Secret To Building Wealth?
- If your goal is to save for the future, the most important concept you can teach yourself is the importance of compounding.
- The magic of compounding requires nothing more of you than the desire and commitment to get started and continuously move toward your long-term financial goals.
- The most important aspect of compounding is time. The sooner you start, the more you will benefit from planning and saving.
Listen to anyone promoting a specific investment and they will tell you that they have found the secret to building wealth. It doesn’t matter if they are promoting penny stocks, mutual funds, options, currency, metals, real estate, or any of the other thousands of investment opportunities that are out there.
But, ask truly successful investors what the real secret to building wealth is, and they will tell you there is no magic investment that will make you rich. While there are always exceptions, wealth is not created quickly or easily and it’s not about picking the right strategy at the right time.
In fact, you don’t need luck, or even skill to build real wealth. Anyone can do it.
What you do need is patience and discipline. You need the desire to improve your future, even if it means sacrificing a little bit of your current lifestyle.
The secret to building wealth is a concept called compounding. It is the most important concept in finance but may be one of the least understood ideas in the minds of the general population.
Compounding is based on the idea of compound interest – making interest on top of interest, or growth on growth.
Here’s how it works.
To understand the idea of interest on interest, compare the following example of compound interest and simple interest.
Start with a $10,000 investment making an interest rate of 10% per year. In the first year of the investment, a 10% return pays you $1,000. At the end of the first year, your account would be worth $11,000. In year 2, add an additional $1,000 bring your total to $12,000. In year three, your account would grow to $13,000.
With compound interest though, you will get interest on your interest by reinvesting past income into the investment. Year one is the same. 10% on the $10,000 initial investment is $1,000. Your account is worth $11,000. But in year two you would get 10% not just on the original $10,000 investment, but also on the previous year’s $1,000 interest payment for an interest credit of $1,100. Your account is now worth $12,100.
The amount of interest begins to grow at an increasing rate. By year three $1,210 in interest is credit, compared to just $1,000 with simple interest.
Here’s the effect.
Here’s why compounding is so important to your future. Every year’s interest credit increases at an accelerating rate telling you that the most important factor in making money is the number of years you let compounding do its work. It’s not the investment choice or even the rate of return you are getting.
Here’s an example of why time is the critical component. Look at two investors. Jane is 35, and Mary is 25. They both want to retire at age 65 and they both can invest $2,000 a year. Assuming an 8% compounded rate of return, Jane will accumulate $264,000 by age 65 if she consistently invests $2,000 a year for 30 years or a total of $60,000. Mary, though, is 10 years younger. She starts investing $2,000 a year at the same 8% rate of return, but she can stop contributing after just 7 year for a total investment of only $14,000. By age 65, she will also have $264,000.
Would you rather sacrifice $14,000 or $60,000 to get the same result? What do you think Mary could do with the extra $46,000?
Here’s the rules.
If your reaction to the story of Jane and Mary is, well, “the problem is I’m not 25 anymore”, then you’ve missed to point. Everyone thinks they are too late. Everyone thinks they missed their opportunity. What you should take away from the story is that you need to get started, no matter what your age is.
As a financial advisor, I’ve consulted with 20-year old’s who came to me in a panic because they thought they were already starting late. My average client starting the retirement planning process was 45.
Wherever you are, just get started. At first, don’t worry about where you are investing, a bank account is fine for a start. The point is to get started moving in the right direction. Teach yourself to become a saver and investor instead of a spender and a consumer.
Make your savings systematic.
Once you make the decision to get started, it’s important to instill discipline in your plan by making your saving consistent over time. Decide on a predetermined saving rate, preferably based on a percentage of your income. More is better, but really, it doesn’t matter if it’s 5%, 10%, or 50% of your income. Setting your savings rate as a percentage is a good strategy because you will end up increasing the dollar value of your investment as your pay increases.
Whatever percentage or dollar value you choose, you need to be consistent. Putting money away periodically, whenever you have some leftover funds, is a recipe for failure.
Make the savings automatic.
You don’t want to have to think about saving for the future, it should happen automatically. The easiest way to accomplish automatic savings is to work with your bank, brokerage, or mutual fund to automatically transfer your set dollar amount from your checking account every month. Set up to transfer funds the day after your paycheck direct deposits; so, you never see the money or accidentally spend it. Another option is to sign up for your company sponsored retirement plan, so it comes directly out of your paycheck.
Every client I have ever worked with starts out saying they can’t save. Every one of them, after just 6 months on automatic savings, say they don’t even notice it. It becomes a part of your monthly routine. Just like your spending tends to grow to match increasing income, it can also shrink as you divert a portion of your income to investments. Saving money becomes a habit.
Compound interest is so powerful, you don’t want to risk losing it by taking investment shortcuts. We all want to maximize returns, but as stated above, time is the most important element here.
Understanding the magic of compounding is the most important concept in financial planning. Get started, and continuously make forward progress. It may seem boring and slow at first but stay focused on your long-term goals. Start with basic investments at first, like bank accounts, and move on to more sophisticated strategies as you learn more and become more comfortable. The key is, just get started.